Unit 3 Managing Financial Resources Decisions
Budget is defined as follow:
- Policies: a budget is based on the policies needed to fulfil the objectives of the entity.
- Data: it is usually expressed in monetary terms.
- Documentation: it is usually written down.
A budget is a part of the financial plan for the organisation. Most business usually prepares a considerable number of what might be called sub-budgets which would be combined with an overall budget known as a master budget.
Budget are useful because they encourage managers to examine what they have done in relation to what they could do.
Budgeting control is when the actual results for a period are compared with the budgeted results.
The budgetary control cycles consist of 7 stages:
1 Responsibilities defined: managerial responsibilities are clearly defined.
2 Action plan: individual budgets lay down a detailed plan of action for a particular sphere of responsibility.
3 Adherence: managers have a responsibility to adhere to their budgets once the budgets have been approved.
4 Monitoring the actual performance management is monitored constantly and compared with the budgeted results.
5 Correction: corrective action is taken if the actual results differ significantly from the budget.
6 Approval: departures from the budget are only permitted if they have been approved by senior management.
- Variances: those that are unaccounted for are subject to individual investigation. (Dyson, J R 2010, p.349 -350)
Purpose of Budgetary Control:
- Forecasting and Planning annual operations.
- Coordinating the activities of the various parts of the organisation and ensuring that the parts are in harmony with each other.
- Communicating plans to the various responsibility centre managers.
- Controlling the gaps by variance analysis.
- Evaluating the performance of managers. (Dyson, J R 2010)
Types of Budgets:
- Direct labour
- Selling and Administration
Before analysing 5 variances of Yuri’s budget we must look at the result obtained.
The labour variance is into 2 components which are rate variance and Efficiency variance.
The labour cost is calculated as the difference between actual labour cost and the budgeted cost. It could be observed that Yuri budgeted £22,500 for the labour but due to the availability of labour Yuri was able to save £ 1,875 from the budgeted labour cost, however, those labour employed by Yuri were not experienced in cutlery manufacture hence the low cost in wage paid out to the labour.
It could be observed that the rate variance which is 3,750 is favourable for Yuri while the efficiency variance is unfavourable.
The budgeted sales were 100,000 but 75,000 was actually sold. This is due to the inexperienced staffs employed by Yuri causing a shortfall of 25,000 units. The efficiency variance which is 5,625 is unfavourable for Yuri making the total variance be 1,875.
The materials variances are 2 components which are price and usage variances.
It could be observed that material budgeted was 15,000 while 22,500 was used. This shortfall was due to wastage by the inexperienced staffs employed by Yuri leading to the total variance of 7,500, hence low productivity. Both the price and usage variances are unfavourable.
- It could be recommended that Yuri should employ staffs that are experienced in cutlery manufacture to minimise wastage of raw materials.
- Also, those staffs already employed by Yuri should be sent on training courses where they will be impacted with skills in cutlery
- Also, staffs must be supervised during production to prevent wastefully and increase efficiency.
- Yuri should seek for the discount when purchasing material.
- Yuri should take greater care in purchasing by exploring the market to get a cheaper material with good quality.
- Yuri should also make sure the budgets are appropriate and not too high.
- More effective use of material with better quality.
- Yuri should employ the service of a marketer for an efficient sales force.
- Yuri should avoid careless purchasing and defective materials.
Direct costs are all expenses which are directly traceable on any cost objects such are materials, Direct labour, Direct Expenses.
Total of all direct expenses are called prime cost.
Indirect costs are all expenses which are not directly traceable on any list objects such as rent, insurance, gas and heat. (Dyson, J R 2010)
Total cost = Direct cost + Indirect cost.
Marked up is the different between the cost of production of an item after adding the cost of direct and indirect cost and its selling price.
Margin this is a profitability ratio which is gross profit divided by net sales multiply by 100 percentages.
1.I would arrive at the total cost for the job by adding all the direct expenses plus the indirect expenses, the addition of both would give the total cost. While the cost per leaflet would be by dividing both the direct cost and indirect cost with a number of items to produce.
- Total production cost = Direct + indirect cost.
Direct costs calculations are paper cost– 204 x £3 = £612
Ink 2 litres at £9 per litre — 2x£9= £18
Labour time :2hours at £15 per hour — 2x 15 = 30
Indirect cost calculations are production overheads and machine utilization overheads – 2 hours at £55 per hour – 2x £55 =£110
Selling, distribution – 2 hours at £20 per hour – 2x £20 =£ 40
Total production cost is 612 +18+30+110+40 = £810
with a 10% mark – up.
810 x 10/100 = £81
The company must quote £891
- For direct cost:
( i ) 2 hours at 15 per hour = £ 30
per hour is £15. So half of an hour is £15/2 = £7.50
15+15+7.50 = £37.50
The budgeted hour readjusted to 2.5 hours would be £37.50
Indirect cost for production overhead and machine utilisation overheads: for 2.5 hours
£55 per hours, so half hour would be 55/2 =£27.50
So £55 +55+2 7.50 = £ 137.50
Selling, Distribution and administration overheads.
Per hour is £20. So half hour would be 20/2 = £10
So for 2.5 hours it would be £20+20+10 = £50
Total cost =Direct + indirect
paper 204 x3 = £612
Ink: 2×9 = £18
Labour 2.5 hours at 15£ per hour would be £37.70
Direct cost: 612 +18 +37.70 = 667.70
indirect cost: 137.50 +50 =£187.50
Total cost = 667.70 +187.50 =£855.20
Marked up price would be
The company must quote £940.72
(ii)Budgeted readjusted to 1.5 hours would be calculated as
For Direct labour time
1 hour = £ 15 so half of 15 is 7.50
£15/2 = £7.50
£15+7.50 = 22.50
Budgeted re adjusted to 1.5 hours’ labour cost would be £22.50
For indirect readjusted to 1.5 hours:
Production overheads @ £55 per hours, half hour is
Selling, distribution and administration overheads at 20 per hour.
Half hour would be 20/2=£10
For 1.5 hours = 20+10 =30
Total Cost =Direct + indirect
Indirect 82.50 +30 =112.50
Total cost: 652.50 +112.50 =£765
10 % Marked up 765×10/100
765 +76.50 =841.50
The company would quote £841.50
Assess the viability of a project
|ARR||Accounting Rate of return||This is a comparison of the profit generated by the invested with the cost of the investment||This shows the profitability of the investment clearly|
Readily available from accounting data
|This does not take into account that future could be less valuable.|
It ignores the qualitative aspect of decision.
|PBP||Payback period||This is the length of time taken to repay the initial capital cost Payback calculates how long it will take to pay back the initial outlay for the investment.|
|It is gives an immediate view on how long it will take to recoup investment.|
May be useful where time scale is relatively short.
might become positive in the research project.
|Does not take accounts of the fact that future returns may be less valuable.|
|NPV||Net present Value||This take into account the fact that money values change with time.|
How much would you need to invest today to earn an in years to come.
|It considers the time value of money.|
amounts of cash flows.
|It is more difficult to calculate and understand than other methods.|
|P I||Profitability Index||This allows a comparison of the costs and benefits projects to be assessed and thus allow decision making to be carried out.||It tells if an investment is increasing or decreasing the firm’s value.|
Takes into consideration all cash flows of the project.
|An estimate about the cost of capital is required so as to calculate the profitability index of a firm.|
|I value RR||Internal rate of return||This allows the risks associated with an investment project to be assessed.|
It is the rate of interest (or discount rate) that makes the net present= to zero.
|With the IRR method advantage is that it shows the return on the original money invested.||At times, it can give you conflicting answers when compared to NPV for mutually exclusive projects.|
(Dyson, J R 2010)
Annual Return = Cost – Resale value/No of year
Profit =Initial Investment – Cash flow.
To arrive at the 1st year profit is 50,000 – 35,000 = 15,000
2nd year 50,000 -30,000 =20,000
3rd year profit is 50,000 -25,000 =25,000
4th year profit is 50,000 – 20,000 = 30,000
Resale value = 10,000
Total profit: 15,000 +20,000+25,000+30,000 =90,000
Annual Return: 90,000 – 10,000 =80,000
ARR = Average Annual Return /Average Investment x100 %
ARR = 160 %
Profit is very good, recovered more than investment.
- (ii) Payback = Days/weeks/Months x initial investment/total cash received.
Initial Investment £50,000
Cash Flow year 1 £35,000
T1 A 35,000
T2 C 30,000
Payback period = A + B/C
Where payback period T1 +15,000/30,000
PBP = 1+15,000/30,000 =1+0.5
The money will be pay back in 1.5 years. This is a worthwhile investment because you are able to recover in 1.5 years
(III) The net present value
Years outflow/inflow DF Net Present Value
0 -50,000 1 50,000
1 35,000 0.9091 31,818.50
2 30,000 0.8264 24,792.00
3 25,000 0.7513 18,782.50
4 20,000 0.6850 13,660.00
Total = 60,000 39,053
Outflow -50,000+35,000+30,000+25,000+20,000= -50+110,000
Net present Value =31,818.50+24792+18782.50+13,660 –50,000
89,053 -50,000 = 39,053
NPV is greater than zero, we should accept it.
Profitability index = Net present value/initial capital cost
Net Present Value = 39,053
Initial capital = 50,000
In this regards Pi< 1
We should reject this.
2. the internal rate of return is the rate of interest (or discount rate) that makes the net present value =to Zero.
- It helps measure the worth of an investment of an investment
- Allows the firm to assess whether an investment in the machine, etc. would yield a better return based on internal standards of return
|The average rate of return||– Compatible with a similar accounting ratio used in financial accounting management. Relatively easy to understand.|
– Not difficult to compute.
|– Net profit can be subject to different definitions, e.g. it might or it might not include the depreciation on the project.|
– Use of a residual value in calculating the average amount of capital employed means that the higher the residual value, the lower the ARR.
|The payback period||-Simple to use and gives an immediate view on how long it will take to recoup investment.|
quickly the cash flow might become positive in the project.
|-Can give an overly simplistic view of situation.|
Does not take account of the fact that future returns may be less valuable.
|The net present value.||-Use of net cash flows emphasize the importance of liquidity.|
|-More difficult to calculate and understand than other methods.|
|The profitability Index||-Tells if an investment increasing or decreasing the firm’s value.|
-Takes into consideration all cash flows of the project.
|An estimate about the cost of capital is required so as to calculate the profitability index of a firm.|